Capital Gains

Avoiding Harm to the State Budget

Published Date : December 5, 2008

Governor Deval Patrick recently took dramatic action to repair a $1.4 billion deficit in the state budget, a hole that is roughly the size of the state’s annual spending on higher education. The plan to fill the gap includes $1 billion in spending cuts and the layoff of 1,000 employees.

The need to act has been driven by a sharp drop in expected tax revenues. Although the ongoing worldwide turmoil in financial markets is unprecedented, the resulting decline in capital gains revenues in response to economic events is all too familiar. So too is the harm to the state budget that ensues.

While every state is scrambling to respond to the budgetary impacts of the economic downturn, Massachusetts has been especially affected. This is due in part to the high concentration of financial services in the state, which, like capital gains, flourish or falter in response to the stock market.

It is also due to our heavy reliance on the income tax to fund the budget, rather than the broad and varied mix of revenue sources recommended by fiscal experts. While our next-largest source of tax receipts, the sales tax, is more stable than the income tax, its ability to act as a counterweight to the swings in the income tax is weakened because of its relatively narrow base.

Despite the known volatility of capital gains, the Commonwealth’s dependence on them has grown markedly since the beginning of the decade. At the same time, however, our preparedness for managing that volatility has declined. In 1999, Massachusetts was already one of the states most dependent on capital gains revenues, ranking 7th in the nation in the relative importance of capital gains for its state budget. By 2006, the importance of capital gains had grown. Massachusetts is now third most at risk among the 50 states if capital gains income declines.

The state has been increasingly relying on capital gains income to fund ongoing spending, including new expenditures that have added considerably to the budget. From 2002 to 2006, capital gains were responsible for $1.2 billion or 54% of the state’s tax growth revenues. This year, roughly $1.5 billion of the budget was funded with expected capital gains receipts, much of which are now in jeopardy.

Just six years ago, inflation-adjusted capital gains revenues plummeted by more than $1 billion, helping to drag the state into a severe budgetary crisis. This was not the first time such a huge drop had occurred. In the early 1990s, capital gains receipts collapsed by almost $900 million, again with dire consequences to the budget.

Learning from that earlier fiscal crisis, state leaders had by the end of the 1990s built up a sizeable budget stabilization or “rainy day” fund that proved critical in blunting the impact of large revenue shortfalls in 2002-2003. Unfortunately, the state has come up short in rebuilding the fund in the ensuing years, even as it has increased its reliance on uncertain capital gains.

The balance in the fund is almost $400 million lower today than it was at the beginning of 2002 after adjusting for inflation. Its share of the budget has shrunk from roughly 10 percent at the fund’s peak in 2006 to only 6 percent for 2009. If the fund’s balance were used to replace 100% of the potential loss in capital gains receipts, most of it would be drained this year, with no end to the current crisis in sight.

Much of the harm from the current decline in capital gains might have been avoided. It is almost certainly too late to protect the budget from that harm. This reality only underscores the need for serious action to fend off future damage to programs and services from difficult-to-predict capital gains.

MassINC provides a series of recommendations that direct policy makers to ways of reducing the unique risks of the tax. Recommendations include: establishing a new capital gains reserve account to even out the flow of capital gains revenues to the budget; using any excess revenues above the account’s ceiling to help build up the existing stabilization reserve; dedicate any additional excess capital gains receipts to one-time purposes directed to the state’s long-term priorities; broadening the state’s tax base, with particular focus on the sales tax.

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